Mind the Gap

Cash flow from operations isn't keeping pace with net income at many companies, and investors are beginning to notice. Our exclusive study of the Standard and Poor's 500 reveals which companies have the widest gaps between the two measures.

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If the stock market is as efficient as it’s supposed to be, then why would CFOs bother to cook up a few pennies of earnings each quarter to meet analysts’ estimates? The answer they frequently give off the record, of course–is that many investors care more about those earnings estimates than about whether those extra pennies have anything to do with a company’s operations.

Judging from recent market activity, however, investors may be wising up. For example, as Q3 2000 came to an end, shares in Eastman Kodak Co., Intel, and Oracle Corp. all took it on the chin, not just because those companies’ earnings were falling short of expectations, but also because sales were disappointing. Shares in IBM Corp. and Motorola Inc. fell even though earnings met estimates, because sales did not. In other words, investors were at least partly discounting earnings management–even if it stayed well within the boundaries of generally accepted accounting principles (GAAP)–and looking hard at both the top and the bottom lines. Their collective expectation, says William Aylesworth, CFO of Texas Instruments Inc., “is more balanced than it used to be.”

So long as that balance persists, CFOs will increasingly find themselves in a new and not entirely comfortable role: They will be called on to help sustain their companies’ revenue growth as well as expansion of earnings. Those who fail to meet the call will find their talents and experience less and less relevant to the creation of shareholder value. “Failing to generate enough top-line growth to meet sales estimates is even worse than not making your earnings numbers,” declares Chuck Hill, director of research for First Call/Thomson Financial Research, a Boston-based firm that tracks analysts’ estimates. The logic is unassailable, says Hill: “That much less is making it to the bottom line.”

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For some CFOs, to be sure, the challenge isn’t new (see “Birth of a Salesman,” CFO, June 1997). But in the face of greater expectations, sustaining profitable top-line growth will become a more urgent challenge than ever. And as more investors become more sophisticated in their appraisal of company performance, capital will surely fly from those companies with consistently large gaps between reported earnings and operating results.

Recently, we set out to determine whether it was feasible to identify which companies, and thus which CFOs, currently have the greatest gaps to contend with. There’s no foolproof standard for tracking how revenue growth is consistently translating into earnings. But one yardstick clearly comes closest: cash flow from operations, that is, the amount of money that the ongoing business throws off. Why? Because that measure is least subject to accounting distortions.

“Net income and cash flow from operations should track pretty closely,” said Howard Schilit, an accounting expert who heads the Center for Financial Research and Analysis Inc., in Rockville, Maryland, at a gathering late last year of the New York Society of Security Analysts. “If cash flow from operations lags behind net income, usually the results are going to be very bad.”

Accordingly, we asked the data-retrieval firm Standard & Poor’s Compustat to compare the growth in cash flow from operations for the companies in the S&P 500 Composite Index with the growth of their net income for the past three years. We list the 100 companies with the greatest growth gaps. More than 50 companies experienced growth in net income that exceeded that of their operating cash flow by at least 100 percent. And of those companies with at least $100 million in quarterly net income as of the end of the three-year period, earnings growth in 29 cases exceeded operating cash flow growth by at least 25 percent.

Noteworthy Chasms

Consider, for example, Eastman Kodak’s yawning gap of 45 percent, which placed it at #90 in the S&P’s Compustat study. Analysts say this reflects the company’s inability to match cost cuts with top-line growth in any of its most promising business segments. In much-vaunted digital cameras, for instance, the company is losing market share to such competitors as Canon Inc. and Sony Corp., according to Benjamin Reitzes, an analyst for PaineWebber Inc. At the same time, says Reitzes, what sales Kodak is generating there could threaten sales of its basic film business.

While Eastman Kodak declined to comment, its lagging cash flow growth is far from the worst among the S&P 500, according to the S&P’s Compustat study. That dubious distinction goes to Ryder System Inc., a Miami-based logistics and transportation firm, whose operating cash flow growth trailed that of its net income during the period in question by an astronomical 67,000 percent. The problem is a legacy of Ryder’s history as a diversified transportation services firm.

“We were almost a holding company” as recently as 1996, notes Ryder CFO C. J. “Corky” Nelson. And while the company exited most of its poorly performing businesses, including consumer truck rentals and school bus services, that cost the company almost 60 percent of its revenues. Meanwhile, the company has had to spend heavily to exploit opportunities in its fastest-growing business segment–corporate supply-chain logistics–and that has held back the stock’s performance. Similarly costly business-model transitions explain lagging cash flow from operations at such companies as PepsiCo Inc. (#61) and Texas Instruments (#6). And high-tech start-ups such as Xilinx Inc. (#14) find their way onto the list because they’ve upped their spending to boost growth (see “Capital Exceptions,” below).

But that’s not the case at some other companies high on the S&P’s Compustat list. Growth in cash from operations at Motorola (#44), for instance, trailed that of net income during the period analyzed by a margin of 128 percent. The company declined to comment, but some analysts contend that for one thing, the bankruptcy of the Iridium satellite communications consortium, in which Motorola invested heavily, has had a significant impact on performance. Indeed, while the company disclosed a $740 million hit to its fourth-quarter earnings last year, these analysts believe the Iridium investment remains a drag on cash flow. During the first quarter of 2000, normally a solid quarter, Motorola posted a $900 million cash flow deficit, its largest in the past nine quarters, according to an analyst who spoke on condition of anonymity. And the company has at least another $374 million to pay on Iridium-related reserves, says the analyst.

To be sure, Motorola also faces profit-margin pressure in several key business segments. In semiconductors, which account for about 20 percent of sales, margins are only in the high single digits. But part of the profit pressure is offset–at least on the income statement–with nonoperating gains. The most noteworthy example came during the quarter that ended last March 31, when Motorola sold an investment booked to the wireless segment. By classifying the gain as operating income, Motorola managed to turn a 41 percent year-over-year decline in quarterly operating income into a 35 percent increase, according to the analyst who requested anonymity.

Recurring Nonrecurrence

Investors often ignore investment gains because they have no assurance that they will recur, and so consider them one-time events that have little bearing on a company’s ongoing fortunes. Whether such gains should be ignored is another matter. Some analysts contend they should not be, at least under narrowly defined circumstances.

In the February issue of SoundBytes, a technology newsletter published by Credit Suisse First Boston, analyst Michael Kwatinetz argued that Cisco Systems Inc.’s investment portfolio, for instance, should be considered part of its ongoing business under four conditions. First, the amount of gains realized in a given quarter must be less than 7 percent of the total (therefore foreshadowing about four years of such gains). Second, the company must intend to consistently take this level of gain. Third, the gains must be a result of investments in related businesses. And fourth, the company’s investment track record must support the notion that further gains are likely. Because Cisco’s investment portfolio meets all four conditions, Kwatinetz wrote, “we believe it’s operational in nature.”

Motorola, for its part, evidently believes its own gains pass muster. How else to explain the fact that such income is used to reduce the figures it reports for sales, general, and administrative expenses? Again, that isn’t necessarily a violation of GAAP. “This use of investment gains is usually disclosed in a footnote,” says another analyst. But he notes that that’s sufficient for purposes of GAAP if the company can claim the impact isn’t material.

Motorola is far from alone in masking operating weaknesses in this fashion. IBM, for instance, used the gain on the sale of Global Network, its telecommunications technology business, to AT&T to reduce its SG&A in 1999 by $2 billion. Cost cutting, of course, translates into more operating cash flow as well as net income. But again, critics contend the accounting treatment, while not a technical violation of GAAP, is misleading. And the fact remains that IBM’s growth in operating cash flow for the three years that ended last March trailed that of its net income by 35 percent. (At #102, IBM narrowly missed inclusion in our list.)

Some companies on the list that have significant investment gains don’t account for them in this fashion. Texas Instruments, for example, enjoyed a big gain from selling a piece of its equity holding in Micron Technology Inc. earlier this year, a stake it acquired in return for selling Micron its memory-chip business in 1998. TI still holds quite a bit of Micron stock. But rather than treat the recent gain as part of its operations, using it to reduce its SG&A and boost its operating income, TI chose to account for it as an extraordinary item. By treating such nonoperational results as noncash items, says CFO Aylesworth, “we get to operating results that are most meaningful.”

But other companies whose cash flow from operations has lagged far behind their net income have employed less meaningful means of reporting their results. DuPont (#79), for instance, switched from accelerated to straight-line depreciation in January 1995, which boosted its earnings without any improvement in its operating cash flow, according to Paul Leming, an analyst for ING Barings. What’s more, says Leming, DuPont “constantly” uses nonrecurring items such as restructuring charges to make its net income look better than cash flow would suggest. Citing quarterly statements that are typically accompanied by dozens of explanatory footnotes, Leming says DuPont is “one of the worst abusers of recurring nonrecurring items,” though he is quick to note that “it’s all GAAP.”

DuPont declined to comment.

Honey, We Shrunk the Revenue

Elsewhere, restructurings have produced earnings boosts that have yet to be matched by operating cash flow growth. Consider PepsiCo’s results. While the company’s moves to spin off its restaurant division in 1997 and take public 60 percent of its bottling operations last year have improved its bottom line, cash flow from operations hasn’t kept pace.

To be sure, the restaurant division itself was performing dismally. With operating cash flow growth trailing net income by almost 4,000 percent, Tricon Global Restaurants, as the division is now known, ranked fourth in the S&P’s Compustat study. Yet PepsiCo’s own performance hasn’t been anything to write home about, with operating cash flow growth trailing net income growth by 82 percent.

In fact, restructuring moves shrank PepsiCo’s revenue growth by about 11 percent from 1995 to 1999, according to CFO Indra Nooyi. And while that has improved the company’s return on invested capital by 5 percentage points, she concedes that “it’s the easiest thing in the world to shrink a company.” She notes, however, that operating cash flow has also increased from $1.4 billion to $2 billion, and that its growth will accelerate in the near future as other moves, including the acquisition of Tropicana last year, produce more profitable top-line growth. Nooyi says PepsiCo’s entire focus since 1995 has been on maintaining a “quality earnings-growth rate in a capital-efficient way.”

The key, she says, is to have a “maniacal” focus on innovation, which she says PepsiCo now works hard to maintain. “We don’t want to run out of good ideas in two or three years,” she says, adding that such a failure would leave the company “dependent on one-time charges or taking costs out of the system.”

Of course, as Nooyi points out, since operating cash flow lags new expenditures on growth initiatives, comparing it against net income in any given year can be misleading–what she calls “a tailpipe indicator.” And despite its relative purity as a measure, operating cash flow can still be distorted by nonoperating items, including, for instance, the generous accounting treatment of the tax benefits of stock options. Here practices vary widely. Microsoft (#51), for one, includes such benefits in cash flow from financing activities, as opposed to operations. But Lucent Technologies Inc. does the opposite, which provides a nonoperating boost to its operating cash flow. (Lucent did not have the requisite 12 quarters’ worth of reported data to qualify for the S&P’s Compustat study.)

Capital Exceptions

By the same token, some analysts contend that focusing on cash flow from operations penalizes profitable and fast-growing but capital-intensive businesses. “Many companies with decent profitability will chew up cash if they’re growing by 25 to 30 percent,” says Bruce Hyman, a credit analyst for Standard & Poor’s. On the other hand, says Hyman, “they’ll throw off cash if growth is slow.”

Hence the huge gap between net income growth and operating cash flow at companies like Texas Instruments. Following a series of divestitures and acquisitions that have repositioned TI in faster-growing markets, the company doubled its capital spending last year to take advantage of growing demand. If anything, it had underinvested previously, according to CFO Aylesworth: “In hindsight, we wished we had spent even more, because now we’re up against some capacity shortages.” But because of TI’s spending, he says, there’s been a lag between cash flow from operations and net income. “TI’s gone through a very considerable transition in the last four years,” he notes. “Our performance during that time hasn’t been as consistent as we think it will be in the future.” Nevertheless, he is committed to strong capital investment, calling it “the lifeblood of the company.”

But why does TI eschew an obvious alternative–outsourcing its manufacturing operations? Many high-tech companies have done just that, leaving everything but chip design to contract manufacturers. Aylesworth responds that TI prefers to do its own manufacturing because it gives the company more control over the quality and supply of its products, and because the “synergies we get from integrating process technology with product technology provide enhancements in our return on capital.” The CFO says TI’s competitors that outsource “are companies that don’t have the capital to invest in billion-dollar wafer fabs.”

In fact, the S&P’s Compustat study suggests that outsourcing one’s manufacturing may not be the panacea that some think it is. One chipmaker renowned for the practice, Xilinx, ranks high (#14) on the list. While CFO Kris Chellam stands by his company’s practice of outsourcing as “the best use of our capital,” that hasn’t eliminated the need for significant expenditures. In fact, Xilinx recently saw fit to retool a testing facility in Ireland to help sustain its growth, allowing Xilinx to test lower-cost versions of its programmable logic chips.

But with testing typically accounting for 10 percent of Xilinx’s production costs, the expenditures on the Dublin plant have caused Xilinx’s overhead expense to rise from 29 percent of revenue to 35 percent. Meanwhile, notes Chellam, net income has been boosted from items not reflected in Xilinx’s operating cash flow, including options-related tax benefits and investment gains on sales of equity interests in two key contract manufacturers.

Others besides TI, Xilinx, and PepsiCo are counting on such strategic changes to yield significant improvement. While heavy capital outlays have cut into Ryder’s cash flow from operations, the company has recently realigned its incentive system to favor marketing and sales of higher-margin services. “We’re no longer rewarding people for unprofitable sales,” says CFO Nelson.

If nothing else, the Standard & Poor’s Compustat study serves to underscore a basic business principle that has until recently been ignored by promoters of “new era” economics. That is, every viable concern must sooner or later produce consistently profitable top-line growth–even New Economy paragons like Amazon.com. Who knows? It may be only a matter of time before all that’s Old Economy is new again.

Ronald Fink is a deputy editor of CFO.

When Cash Flow Really Counts

The wide variation in shareholder returns produced by the companies in the Standard & Poor’s Compustat study suggests that investors don’t necessarily care if growth in operating cash flow trails that of earnings. Nonetheless, analysts contend that the gap can be a useful measure of operating performance.

While cash flow may move in a different direction from earnings in one period, a pattern typically develops over the course of two or three years, says Howard Schilit, president of the Rockville, Maryland-based Center for Financial Research and Analysis Inc. “We look for changes in the pattern,” says Schilit.

But what amount of change raises a red flag? “There’s no rule of thumb on what is normal,” says Schilit, “but if you look at enough graphs, you can spot something.” He cites the case of Oxford Health Plans Inc., whose stock plunged more than 62 percent on a single day in October 1997, after the HMO said it would report a loss. Schilit had warned his clients ahead of time. “Cash flow and net income had moved pretty much in sync,” he recalls. “Then we noticed a break in the pattern, where net in-come continued rising while cash flow from operations dropped like an anchor.”

Other analysts say that investors will pay more attention to operating cash flow if the recent market slide continues. “I think if we get into a slow period in the economy, people will focus more on cash flow,” says Chuck Hill, president of First Call/Thomson Financial Research in Boston. “So those companies where there is a gap [between earnings and cash flow] are probably not going to make out as well.” —R.F.

Where the Gaps Are

The 100 companies in the S&P 500 with the widest growth gaps between net income and cash flow from operations, 1997-2000.

For “date of data”: Results are for 12 consecutive quarters ending in the quarter indicated, the most recent quarter for which data was available at the time of the study. Some numbers may not add up due to rounding.

For comparison with the “3-year shareholder return,” the total shareholder return for the S&P 500 from March 31, 1997, to March 31, 2000, was 107%.